Timing is everything

Vol #21 - January 15th, 2021

The pacing and delivery of a punchline has as much of an impact on the joke as the words that are spoken. If you flub the timing, it’s worse than a bad pun.

Options trading has the same requirement of finesse. When contracts expire within days, weeks, and months, your proposition has a defined timeframe. It’s not just direction you have to be right about, it’s timing also.

A potential client called a few weeks ago with a very interesting problem. He had particularly keen insight into the impact of a certain company’s research and development efforts on his own business. Far from inside information, this was professional expertise that was observing the competitive landscape.

The client was looking to the options markets as a way to make a trade that would mitigate the impact to him of this company’s development prospects. If they were successful, it would put a crimp in his practice. Betting on the competition’s success meant his income stream would be hedged.

He knew that something was cooking, and that it would likely be soon. Was there a way to use near term options to hedge this risk?

Companies with speculative products tend to trade at elevated implied volatility levels. The options traders job is pricing the known unknowns. If there’s a scheduled announcement like earnings or Phase III trial results, the prices of those options are going to be more expensive to compensate for the known uncertainty.

Talking through some of the potential scenarios, we started comparing different convexity plays. If this stock had the potential to double upon successful product development, what options were available?

Betting on the doubling of a stock sounds like it has the potential to bring a big pay day. But when everyone else knows that something else is out there, it gets expensive fast. Assuming it was going to happen in the next 90 days, was going to require putting up 10% of the desired reward. If the stock didn’t increase by at least 40%, all of that was gone. Adding another 90 days of time to the window of opportunity would double that initial outlay.

While there was near term convexity available at cheaper prices, that would require many more trades, which also adds up. Unless you had a high degree of confidence about the when and the what, you would end up buying very expensive options.
This example resonated with me because it emphasizes the importance of systematic exposure. Even with unique insight, it’s hard to find a trade that’s a slam dunk value proposition.

We don’t know when stocks are going to rise or fall, and the options market is the competitive landscape that is dynamically pricing those probabilities. At Harvested Financial, our strategies are about staying exposed over time to fundamental forces in the market. While the markets will tick up and down based on daily flow dynamics, certain factors persist.

If you get the timing right, you could find yourself on an HBO special. But absent that magic touch, we’re happy when our dad jokes land consistently.